Every stock investor should understand how bonds work, but if you are new to the stock market it can be confusing to try to comprehend all of the many different types of financial investments.
Bonds are considered the “other side of the coin” in relation to stocks, and they can sometimes help to keep your portfolio afloat during troubled financial times.
What is a Bond?
A bond is essentially an “IOU” written by a corporation, a government, or an agency which covers money the bondholder has lost. As opposed to being a part owner of the company as you will be when you own stock, by being a bondholder you are actually a creditor of the company. The bond is a formal contract which states that the company must pay you back the money that they have borrowed, including interest at certain fixed intervals.
A bond is very similar to a loan. As the bond holder, you are the lender and the issuer of the bond is the debtor. By buying bonds you allow the company to finance their investments or their current expenditure.
Most bonds will have a defined term of maturity, and then it can be redeemed. Once the bond has been paid, the issuer has no more obligations to the bond holder. Usually the interest rate which is paid on the bond is fixed throughout the entire term, but it can sometimes vary with a money market index.
Check the Credit Ratings
Before buying a bond, it is a good idea to check the credit rating of the company so that you know whether or not the investment will be risky. You can do this by using an independent bond rating agency.
Why Invest in Bonds?
This is not as exciting and high stakes as dealing with stocks, but having bonds can make your portfolio more balanced. Many financial advisors will recommend that you invest in bonds in order to diversify your portfolio.
One of the advantages of bonds is that they pay interest semi-annually which means that they will provide you with a reliable and predictable income stream. They are considered very safe and conservative investments because you can rely on them even though they will not likely bring in enormous returns.
If you need to borrow money in an emergency, you might be able to use your bonds as collateral instead without having to sell them. Most banks will accept them, and the interest income that you earn from a bond will likely be enough to pay the interest charges on a loan.
Bonds perform much better than stocks in times of economic turmoil, so in a situation where stocks are suffering your bonds will help you compensate during the recession. Bonds are popular with retirees, who will want to rely on the predictable income for their retirement years. The interest rates on most bonds are higher than you could receive by placing your money in a savings account.
Bonds are a very important part of your investment portfolio, so why not find out if there is a bond out there that is right for you?
Simon Grant wrote this on behalf of Ulster Bank, who are a supplier of tracker bonds.